Part I: Measuring Potential to Create Value

By Roxanne Lo

How do you measure a business’s ability to scale while creating value?

As Venture Capitalists, we spend much of our time looking for the businesses that have the greatest ability to create value based off of the capital we invest. But the industry standard metrics measure only one aspect of the complex reality and fail to capture the full picture of the business’s performance. This leads to a complex juggling act of how the plethora of different metrics fit together and push and pull on one another.

That’s why we’ve gone back to the drawing board and developed a framework to measure the core of the businesses we look at — spending on (investing in) sales and marketing today to drive value further down the road — which is a simple conversion determined by the ratio of dollars invested to value created. We call this ratio the “Core Ratio” and like to think of the business like an engine that converts fuel (capital, today) to miles (value, tomorrow) at a rate determined by the miles per gallon (Core Ratio). All other efforts (team, product, …) should be an effort to increase the efficiency of this engine because that is what determines the value of the entire business.

Take a business with 50% margins that spent $100 to acquire customers in January. If that same group of customers (the January cohort) spent a cumulative total of $300 through the following December, the Core Ratio after 12 months would be 1.5, calculated as 0.5*300/100.

The Core Ratio provides a high level view on a company’s ability to create value. By looking at the Core Ratio and its three drivers — revenue retention, contribution margin and revenue acquisition cost — decision makers can measure performance and drive strategic decisions around product, growth and the business model itself.

The Core Ratio has a massive impact on a business’s capital needs. Between two companies with identical opex, revenue and growth, the company with a 2x better Core Ratio will burn less than half the cash in a given period and hit break-even much earlier, leading to much lower dilution for common shareholders and early investors.

Together with our sister fund, e.ventures, we’ve created software that helps us run this analysis programmatically based off of simple inputs. Here’s an example with demo data. We’ve found this tool (we call it the Data Interface) to be helpful both for us to determine the fuel efficiency of companies we’re looking to invest in, as well as our existing portfolio companies. We’re currently in the process of opening this tool up to let entrepreneurs outside our network quickly run the analysis on their business. Send an email to jonas[at]eventures.vc for a chance to be among the first companies to test the Data Interface in the coming months.


Written by: Thomas Gieselmann and Jonas Nelle

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Part II: Visualizing the Core Ratio – The Realized Core Ratio

By Roxanne Lo

This is the chart we at e.ventures use to visualize the Core Ratio, the efficiency of a company’s economic engine. We call this chart the “Realized Core Ratio”. The Realized Core Ratio is simple to calculate and makes no guesses about the future.

We standardize this chart to always look at the Realized Core Ratio on a scale from 0–6 over 36 months of cohort data. When the cohorts cross the line at 1.0 they have achieved payback. We also look at the slopes of the individual lines to gauge the retention rate.

‘Vertically slicing’ this Realized Core Ratio chart, we can look at trends over time and answer questions such as, ‘Has our Core Ratio after 4 months become better or worse for recent cohorts?’.

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Written by: Thomas Gieselmann and Jonas Nelle

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Part III: Drivers of the Core Ratio – Retention, Margin, Acquisition

By Roxanne Lo

Often, entrepreneurs need to ask more detailed questions, such as ‘How did our new feature improve the business?’ or ‘Why is the cohort from January outperforming other cohorts?’. This is where we drill down into the three fundamental drivers of the underlying economic engine:

  1. Margin

The ratio of marginal costs to revenue: ‘What is the revenue and cost of selling one more unit?’. Examples of line items we would include in the margin are the cost of product, shipping costs, payment processing costs, returns, customer support, retention marketing, server costs and packaging.

2. Sales and marketing efficiency

There are a number of ways to dive deeper into sales and marketing efficiency, from the magic number to Customer Acquisition Cost (CAC) and many more. We usually look at fully loaded spend in order to maintain comparability across businesses but marginal spend can be more accurate for early startups with high fixed (salary) costs.

3. Retention

Revenue retention takes into account upsell to existing customers as well as customers decreasing their spend or churning altogether. We look at this data by cohort and over time.


 

Written by: Thomas Gieselmann and Jonas Nelle

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Part IV – Averages Hide Shit

By Roxanne Lo

Conceptually, the Core Ratio is similar to the well-known LTV:CAC ratio, which measures the return (LTV) on investment (CAC). We moved away from LTV:CAC ratios because they are based on guesswork to estimate customer lifetimes and because they involve complicated math with differing opinions on formulas, definitions and time frames. No matter how you calculate your LTV:CAC ratio, someone will point out an aspect of the data the LTV:CAC ratio fails to capture and they’ll be right.

The LTV:CAC ratio is expressed as a number, which is an average over time and over many cohorts. Averages hide information because they obscure trends over time and hide details by aggregating different customer groups.

Averages are easier to grasp and remember, but end up being a cognitive shortcut that is more costly than most people realize.

One aspect of data that averages can hide is extremes: A statistician drowns in a river that is, on average, three feet deep. In this example the relevant metric for the statistician is not the average depth but the maximum depth. This is why we look at distributions instead of averages.

Averages also hide trends. For example, a LTV:CAC ratio of 3 that has been steadily improving over the last 2 years is better than the same ratio of 3 that has been steadily declining. Reducing LTV:CAC down to a single number erases this critical information.

Lastly, averages hide the fact that not all improvements over time are created equal. A LTV:CAC ratio of 3 that has been steadily improving because the sales and marketing team has figured out how to scalably grow the business is better than the same ratio of 3 that is improving because a small group of loyal customers have started spending more. This is why we look at all metrics, including the Core Ratio, over time and on a cohort-by-cohort basis.

 


Written by: Thomas Gieselmann and Jonas Nelle

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Part V – Case Study

By Roxanne Lo

Here’s a case study of a company that we invested in, in large part due to its phenomenal Core Ratio.

This chart shows the Realized Core Ratio. The Realized Core Ratio portrays a business with a strong underlying economic engine, with most cohorts paying back in less than 5 months so far.

But as these next charts show, the Core Ratio is getting worse on average. These charts each show the Realized Core Ratio after 1, 2 and 3 months as a function of the cohort birthmonth.

In order to understand why this business is doing so well but has been slightly worse recently, let’s take a look at each of the three underlying drivers of payback period: margin, sales and marketing efficiency and retention.

  1. Margin

The company’s margins have remained between 30% and 45% and have steadily increased over the past 12 months.

2. Sales and marketing efficiency

A typical measure of sales and marketing efficiency is the Customer Acquisition Cost (“CAC”). The CAC measures the number of Sales and Marketing (“S&M”) dollars spent for every new customer.

In this case, it turns out that the CAC shown above hides critical information. In fact, the increase in CAC is explained the greater costs to acquire customers in a new market. In aggregate, CAC is increasing because the company is adding new markets at an increasing rate. The CAC in the company’s oldest market is constant at around $15 and trending downward in nearly all markets.

3. Retention

The best way to measure improvement in revenue retention is to look at the retention in any one lifemonth across cohorts. Each of these charts shows retention in one lifemonth (2, 3, … left to right, top to bottom) for all cohorts. An increasing trend line indicates improving retention.

In this case, revenue retention is improving dramatically across all cohorts, which is highly unusual and a strong sign of better retention marketing and/or a significantly improved product and user experience.

 


Written by: Thomas Gieselmann and Jonas Nelle

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